Will Italy Need a Bailout in 2013?

Even as markets have been focused on a potential bailout for Spain, analysts say Italy, which is heading for a protracted recession, may also need aid in 2013.

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Although Mario Monti's technocrat government forecasts the Italian economy will decline only marginally in 2013, analysts at Citi predict a steeper contraction of 1.4 percent, after a 2.3 percent fall this year. Meanwhile, the Organization for Economic Co-Operation and Development lowered its 2013 estimate for Italy on Tuesday to a one percent contraction.

On top of the economic weakness is growing political uncertainty. Monti's term ends next year and former Prime Minister Silvio Berlusconi, who has lashed out at the government's austerity measures, has hinted he may run for election again.

(Read More: Italy's Berlusconi Hints He May Run in 2013 Election)

"We still see as our baseline scenario that Italy will likely be forced to ask for an international bailout at some point in 2013," said Citi Analyst Giada Giani in a report on the country.

"Italian economic fundamentals have not really improved, despite some improvement in market conditions. The negative feedbacks from fiscal austerity on growth have been severe, as the ability of the private sector to absorb fiscal tightening by lowering its saving rate is limited."

Economists at other banks and research institutions agreed that Italy's recession will be deeper than financial markets are currently pricing in.

"The composition of austerity so far — skewed towards increases in taxation rather than cuts in expenditure — and the tight credit conditions, will weigh very negatively on the economy and the market will have to take stock of it," said Nomura Economist Silvio Peruzzo.

"Weaker growth will have implications for fiscal plans and debt sustainability and could trigger a return of tensions."

(Read More: Italy PM Monti Wins Confidence Vote on Budget Plan)

Mark Willis, an economist at Roubini Global Economics, said market focus on Greece's and Spain's economic woes had distracted investors from the structural weaknesses inherent in both Italy's economy, and its political system.

He added that Italy suffered from three "core vulnerabilities" of weak growth, very high levels of public debt and regular bouts of political instability, the latter of which is likely to reappear in the build-up to the spring 2013 general election.

"A period of relative — albeit temporary — political stability over the last 12 months has allowed the Monti-led technocratic government to pass a number of economic reforms, that would have utterly unimaginable under a Berlusconi premiership," said Willis.

"Even under the optimal scenario of a continued Monti premiership — quite likely in the event of a hung parliament — Italy will not experience a stable political equilibrium, with the support of a wide number of different political parties needed to secure a parliamentary majority. Likely inter-coalition ideological disparities will severely curtail the pace of structural reform, which will proceed slowly at best," added Willis.

Nomura's Peruzzo said that as a result, market sentiment on Italy is likely to wane as the election nears. "The political risk is adding up to the macro risk, and heading into next year we believe there are conditions for Italy to face further market turbulences."

However, UBS Economist Matteo Cominetta was more bullish on market outlook. "I think fiscal consolidation will indeed continue whoever wins the elections, and this is what counts for markets in the long run," Cominetta said.

"Reforms already passed will not be touched. The liberalization of product markets should continue, however the Public Administration and Judiciary system reforms will probably stall, since a left-wing government is likely to come out of the next elections. But in general I think the reformist effort should continue."